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Ladder Capital: Fear Highlights Risk, Creates Opportunity

Ladder Capital (LADR) is a Mortgage Real Estate Investment Trust (mREIT) with a big +9% dividend yield, and the yield climbs to ~+20% if you count the additional special dividend that was paid in December of 2015. The company generates an after tax return on equity of over 12%, and it trades at a discount to its book value. The stock is 30% lower than it was a year ago because the market has already baked significant fear into the price with regards to commercial real estate valuations, rising interest rates, widening credit spreads, decreased Commercial Mortgage Backed Securities (CMBS) issuance, and an increasingly challenging regulatory environment. However, barring a complete commercial real estate market collapse, now may be an excellent time for investors to consider adding Ladder to the higher-risk portion of their diversified long-term income-focused portfolio.

What Does Ladder Do?
Ladder is an internally-managed commercial real estate finance REIT. Ladder’s main investment activities include loan origination, securities investments and real estate equity.  As the following chart shows, Ladder’s earnings come from diversified business segments consisting of 80% debt assets and 20% equity assets. 


Why Has Ladder’s Price Fallen?
Ladder’s price has fallen for a variety of reasons including fears related to commercial real estate prices, rising interest rates, widening credit spreads, decreased Commercial Mortgage Backed Securities (CMBS) issuance, and an increasingly challenging regulatory environment. With regards to commercial real estate prices, the following Green Street Advisors chart shows that market prices have been on the rise, and are now well above pre-financial crisis levels.


Similarly, the SIOR Commercial Real Estate Index shows that commercial real estate experts believe the market is now stronger than they believed it was right before real estate markets collapsed during the financial crisis.  


These strong commercial real estate readings lead some investors to believe the markets are becoming too hot or frothy. And they are beginning to express their views by putting selling pressure on mREITS such as Ladder.

Fear of sharply rising interest rates is also contributing to pressure on mREITS like Ladder. Specifically, if rates rise sharply, it will reduce the buying power of investors, and put downward pressure on the market prices. According to a recent Barron’s article, “mREITS aren’t trading on individual fundamentals… It’s all about the interest-rate outlook… A rapid rise in the 10-year Treasury’s yield would torpedo mREITs.” And considering the US Fed has already started to raise rates (and given indication that more rate increases are coming) commercial real estate has been impacted negatively. 

Widening credit spreads are also indicating fear among commercial real estate investors. The following chart from a recent Trepp article shows spreads widening versus 6-months ago and a year ago. 


According to a recent Barron’s article, 2016 has been trying for CMBS, but the selloff has not been as pronounced as previous corrections. The article notes spreads remain an average of 20% below prior corrections.  

A decrease in CMBS issuance has also contributed to the selloff in mREITS. According to Trepp, issuance plunged 32% in the first quarter of 2016 versus the same quarter a year ago. These conditions put pressure on Ladder.

Increasing regulations also put pressure on Ladder and mREITS in general. For example, in January the Federal Housing Finance Agency established new standards which impacts the mREIT space negatively. And according to Ladder CEO, Brian Harris, “Dodd-Frank… it is absolutely causing liquidity problems.”  

Why Is Now A Good Time To Consider Ladder?
Aside from a big 20% dividend yield, there are multiple reasons why now is a good time to consider an investment in Ladder. For starters, Ladder currently trades at a discount to its book value. Specifically, the current stock price represents more than a 10% discount to its most recent book value of $13.59 per share (and this doesn’t even take into consideration future earnings power).  Additionally, the company’s average return on equity exceeds of 12%. In our view, the market is pricing in a dramatic decline in commercial real estate, but this seems unlikely given the reduced risk taking and increased regulations since the financial crisis. As a point of context, Morgan Stanley analysts recently clipped their commercial real estate appreciation forecast for 2016 from 5% to 0%. And while this is not preferable, it’s still not a dramatic decline. It’s an environment where Ladder can continue to be profitable.

Ladder management also believes their stock is undervalued. During the most recent conference call, CEO Brian Harris explained “Unfortunately, our current stock price is trading at a fairly steep discount to book value…[as low as] 65% of book value in mid-January.” On a separate note, and worth noting, management’s interests are aligned with shareholders considering “management & directors own 11.2% of the company’s $1.3 billion total market cap.”

Ladder’s investments are highly diversified. In addition to investing across business segments (loan origination, securities investments and real estate equity), Ladder is also diversified geographically as the following chart shows.


This is noteworthy considering they’re not overly concentrated in energy-heavy regions because the recent declines in energy prices could have a very negative impact on commercial real estate in those areas. According to Ladder’s recent conference call transcript, the company does not have heavy exposure in certain oil rich areas and fracking towns like North Dakota and Houston.

Ladders investments are high credit quality.  For example, senior secured assets represent 78% of Ladder’s $5.9 billion total asset base as of 12/31/2015. Ladder isn’t investing in high-risk “subprime mortgages,” but rather in highly rated loans and CMBS. The CMBS portfolio is 87% AAA-rated and 99% investment grade-rated. Further, Ladder’s disciplined credit culture has resulted in zero credit losses since its inception.

What Are The Risks?
Ladder faces a variety of risks in addition to those described previously (e.g. volatility in commercial real estate markets, rising interest rates, widening credit spreads, decreased CMBS issuance, and new regulations). For example, Ladder’s business is highly leveraged, which could lead to greater losses than if they were not as leveraged. The following chart shows Ladder’s historical leverage. 

If asset prices were to fall, that could increase leverage ratios and make it harder for the company to operate profitably and also expose the company to greater potential losses.

Regulations could also adversely impact Ladder’s business and operations. We’ve already seen examples of this via Dodd-Frank and the Federal Housing Finance Agency’s new rules. Also, maintenance of Ladder’s exemption from registration under the Investment Company Act imposes significant limits on its operations. Further, complying with REIT requirements could limit Ladder’s ability to hedge effectively, and it also may force them to forgo otherwise attractive investment opportunities. Additionally, if Ladder fails to qualify as a REIT in the future, that could subject the company to substantial new tax liabilities which could jeopardize the dividend. 

We like Ladder Capital because of its big dividend and discounted price. And despite market volatility, we believe it’s a company that can be profitable for many years to come. Barring a complete commercial real estate market collapse, we believe this mREIT could be a valuable addition to the high-risk portion of a diversified income-focused portfolio. It’s a bit of a contrarian play to own mREITS when interest rates are expected to rise and asset prices may begin to slow, but we believe a lot of negativity is already baked into the price and the shares currently trade at an attractively discounted price.

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